March 30, 2009

Simon Johnson's morality tale

Simon Johnson tells a simple and compelling story: the U.S. has been afflicted by a version of the crony capitalism that has been the scourge of so many emerging markets, except that Wall Street has bought its influence and power not by bribery but by shaping the ideology of our times:

In a primitive political system, power is transmitted through violence, or the threat of violence: military coups, private militias, and so on. In a less primitive system more typical of emerging markets, power is transmitted via money: bribes, kickbacks, and offshore bank accounts. Although lobbying and campaign contributions certainly play major roles in the American political system, old-fashioned corruption—envelopes stuffed with $100 bills—is probably a sideshow today, Jack Abramoff notwithstanding.

Instead, the American financial industry gained political power by amassing a kind of cultural capital—a belief system. Once, perhaps, what was good for General Motors was good for the country. Over the past decade, the attitude took hold that what was good for Wall Street was good for the country. The banking-and-securities industry has become one of the top contributors to political campaigns, but at the peak of its influence, it did not have to buy favors the way, for example, the tobacco companies or military contractors might have to. Instead, it benefited from the fact that Washington insiders already believed that large financial institutions and free-flowing capital markets were crucial to America’s position in the world.

The solution, to Simon, is equally clear. Finance needs to be cut down to size. What the U.S. needs is what the IMF would have told any country:

The challenges the United States faces are familiar territory to the people at the IMF. If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say: nationalize troubled banks and break them up as necessary.

...

The second problem the U.S. faces—the power of the oligarchy—is just as important as the immediate crisis of lending. And the advice from the IMF on this front would again be simple: break the oligarchy.

As with any story built around clear villains easy solutions, there is something in this account that is quite unsatisfying. For one thing, I think it puts the blame too narrowly on the bankers. Yes, there can be little doubt that banks badly misjudged the risks they were taking on. But they were aided in all this by the broader economics and policymaking community--not because the latter thought the policies in question were good for bankers, but because they thought these would be good for the economy. Simon himself says as much. So why pick on the bankers? Surely the blame must be spread much more widely.

And I find it astonishing that Simon would present the IMF as the voice of wisdom on these matters--the same IMF which until recently advocated capital-account liberalization for some of the poorest countries in the world and which was totally tone deaf when it came to the cost of fiscal stringency in countries going through similar upheavals (as during the Asian financial crisis).

Simon's account is based on a very simple, and I believe misguided, theory of politics and economics. It is an odd marriage of populist and technocratic visions. Countries fail because political elites always end up in bed with economic elites. The solution, apparently, is to let the technocrats (read the IMF) run your affairs.

Among the many lessons from the crisis we should have learned is that economists and policy advisors need greater humility. Too many of us thought we had the right model when it turned out that we didn't. We pushed certain policies with much greater confidence than we should have. Over-confidence bred hubris (and the other way around).

Do we really want to exhibit the same self-confidence and assurance now, as we struggle to devise solutions to the crisis caused by our own hubris?

Comments

Your points about Johnson's oversimplification of the narrative and the folly of looking to the IMF for solutions are well taken. But I don't read Johnson's article to put the blame for the current mess solely on the bankers. Johnson clearly describes several political and policy missteps that brought us to this point. The article does not merely seek to assess blame for the crises but to examine the difficulties of resolving the crises, of moving forward. If he focuses on the bankers it is because at this point they are an entrenched interest with the most to loose from a proper resolution to the crisis, which Simon believes to be nationalization. The policies of the last 40 years have created an enormously powerful industry that will not go down quietly. And they have an enormous amount of sway over the policy makers in D.C. Just look at the events of the last few days. The heads of the biggest banks in the country get a pleasant meet and greet with the president to discuss the problem. The head of GM, our largest auto maker, gets the ax.

I have been a long time fan of your writing and this blog, but I am sometimes mystified by the seemingly sectarian fights you pick with what I will dub "modern political economists". I say 'sectarian' because you made so many seminal contributions to understanding the political economy of policy reform.

Dani Rodrik writes: "they were aided in all this by the broader economics and policymaking community--not because the latter thought the policies in question were good for bankers, but because they thought these would be good for the economy."

Isn't THIS risking being "simple"? Do you believe the main reason we got a repeal of Glass-Steagall, and so many other changes to radically deregulate and relax supervision is because "policymakers" felt it was good for the country?

A far more compelling story is that a very powerful banking lobby spent hundreds of millions of dollars over many years to elect and then influence enough legislators to get the changes made; and that the revolving door relationship we have between financial industry and government, made it all that much easier. Why else were the banks spending all that money?

In nothing that I have read is Simon Johnson saying that he has simple technocratic solutions (I agree with you thought that little is said of the IMF's many problems in his tales). What he has written on looting and tunneling for instance suggests just how hard and messy it is to regain control over policy.

What I read him to be saying is that when economic policymaking is partly captured, and that those individuals that have earned massive economic rents at the helm of large financial institutions that are now insolvent will very rationally fight hard to hold onto their privileges and loot the treasury if necessary to do so. Why wouldn't they?

Finally he is saying that any lasting meaningful reform that gets us out of this crisis, that doesn't just socialized bankers losses, and that helps to make sure we don't repeat this all again any time soon MUST start (or at least end) with an effort limit the power of these economic elites to exert so much political influence (and systemic risk) again.

Your alternative seems to be to share the blame with economists and policymakers and their blind belief in models of one sort or another. But where do they come from? Models of the sort that are taught in the business schools or simplified by CNBC anchors are not chosen randomly out of an urn. Business schools are in the business of selling ideas -- and guess who has been paying?

Sure there is blame to go around, but it's hard to think of an explanation that does not put bankers and their influence square in the middle of this one.
More importantly, it's hard to see how to put in place better policies (and hence put better models to work) without confronting the economic and political power of this sector. Do you?

There has been a deliberate effort by the "vast rightwing conspiracy" to influence public policy and promote the ideas of libertarianism and the free market.

The (mostly hidden) players in this effort are known: Scaife, the Koch brothers, Olin, Ahmanson, etc. This group is behind the well-funded conservative think tanks: Hoover, Hudson, Cato, Manhattan Institute and the rest. They have also supported the economics departments at U Chicago and George Mason.

I refer you to the useful web sites run by Source Watch and Media Transparency for details.

This is what I wrote in the comment section of Baseline Scenario. You are making the same point. Simon and James Kwak are good and logical writers but are looking for easy targets than root causes. Whoever suggests that IMF and technocrats are the solution ought to go talk to people in Indonesia and ask them how did relying on their advice work out for them. "For obvious reason, some commentators have hijacked the process of analyzing the root cause of the current crisis to get to their pet peeve. The crisis, first and foremost, was the result of monumentally wrong policy judgements — using US consumption and the consequent debt growth to ward off the negative wealth effect of the busting of an equity bubble — compounded by blind mercantilist policies of Asia’s net exporters — unprecendented reserve building after the Asian crisis (and following the IMF advice a bit too closely, in fact). Clearly, growth of the financial sector and bankers’ pay was the consequence of these bad judgements on the part of policy makers and foreign politicians, rather than the root cause of all evil in the world. In the current political environment, if you repeat the base assertion frequently enough — as you and others have been doing — it will of course stick. But that does not make it the correct root cause analysis. Banks and bankers are easy targets right now but focusing on them exclusively will not fix the global order — doing something about reducing consumption and increasing savings in the US (perhaps not in the near term but definitely in the medium to long term) and increasing consumption and reducing currency subsidised exports in the developing world will go a long away. You should be focusing on those issues rather than take easy shots at banks and bankers. That’s like trying to solve the drug problem by arresting the street drug peddlers."

You say, "Clearly, growth of the financial sector and bankers’ pay was the consequence of these bad judgements on the part of policy makers and foreign politicians, rather than the root cause of all evil in the world."

May I ask for one example in which the financial services industry, the largest donator to presidential and congressional campaigns and the industry with the largest lobbying expenses, ever opposed the bad judgments on the part of the policy makers and foreign politicians? Clearly, they had power; I'd like a single example of them using it for good instead of evil.

I'm not, BTW, absolving the politicians, only asking why you are using the politicians to whitewash the financiers. Or are you really, honestly suggesting that people on Wall Street didn't understand (1) what "to big to fail" meant, and (2) how to profit from that status? Maybe I'm a cynic but I'm find too many examples of Wall Street doing exactly that. Your analysis suggests that the politicians are adults and thus morally culpable, while people on Wall Street are children, in the sense of being pre-moral. If true, something we should think about before allowing them to fund the political process, no?

Thanks for your thoughtful comments (and the kind words about my own research).

The conundrum in which the practitioners of "modern political economy" find themselves is the following: either you say that policy is determined by the interests of the politically powerful (here, banks), in which case you are left with no way out (banks will remain powerful and veto any meaningful reform). Or, you accept some autonomous role for the intellectuals and policy makers to make a difference, in which case, you can hardly attribute all the blame for the mess on the special interests.

Failure to account for the fact that both forces are at play simultaneously results in the kind of attitudes I was objecting to: holier-than-thou moralism about the insidious effect of the banks (as if economists weren't equally complicit); preference for technocratic solutions (as if the IMF wasn't equally under the influence of Wall Street and the U.S. Treasury); and over-confidence on the technocratic policy recommendations of the moment (as if we had not been equally confident on the previous set of policies that brought us here).

Ignoring the portioning of blame, I thought the most poignant point (which Simon Johnson certainly isn't the first or only one to raise) but which I've yet to see addressed on the path we are currently on, was summed up in one simple sentence:

"Anything that is too big to fail is too big to exist."

Whoever you choose to blame, and whatever your beliefs on who wields power in these situations, can we allow businesses to grow to the point where their failure would devastate our entire economy?

Thanks for your thoughtful reply which helps explain your position much better.

It seems however that you are lumping "modern political economists" in together with an older and cruder camp of material determinists who, as you suggest, saw little or no possibility for 'autonomous' policy decisions to take their countries 'out of the periphery' or out of the clutches of 'bad elites'.
But my take-home lesson from the modern political economy literature -- and again this is very much influenced by reading *your* seminal works in the early 1990s on the political economy of adjustment and reforms -- is that the policies that prevail are the outcome of political contests that are conditioned on the balance of power between different interest groups, but that cannot be always perfectly predicted (except perhaps probabilistically). .
What I have also learnt from you is that autonomous policymaking plus good policy choices was necessary for success outcomes in several places, with Asian NICs being the most frequently cited. That's an important and hopeful lesson.
But embedded in this very definition of "autonomy" (pardon the intentional pun) is how much room for maneuver these governments have been able to create by insulating themselves from the strong organized attempts by economic elites to impose their prefered policies. So the real question is what determines the space for 'autonomous' decision making.
The concern that I think many of us have is that the room for autonomous policymaking in the USA has been reduced in recent years because of the rising influence of a powerful financial sector and it's political allies.
Sure I blame Larry Summers, Alan Greenspan and other policymakers for failing in the 90s and later to regulate or provide proper oversight of fast growing derivative markets that proved capable of massive destruction to the economy and the innocent. Those people do deserve blame.
But had those particular people not been there it seems very likely that other people of very similar persuasion, acceptable to the 'business community,' would have been hired instead. The politicians who appointed them would make the same political calculation that challenging the very powerful banking lobby (and its generous political contributions) did not make sense. From reading Summers own writing it is not evident that he would have always chosen not to regulate. Hence I suspect his decision was at least in part political, and not just ideological.

In summary the power of the banking industry seems a deeper structural problem that helps understand the policy choices. More so than blame we might assign to particular economists, although it is possible to imagine a more courageous politician or policymaker who might have made a difference.
In the present political battle over policymaking as citizens and as taxpayers we should get behind people like Simon Johnson who are at this time the ones most loudly and clearly saying that whatever new financial system is to emerge, it should beone where there are no more banks politically or economically too big to fail.

And just because that might sound like a morality tale, doesn't mean they are not scheming to put in the fix.

p.s. -- on what we can certainly agree, and it is unfortunate that Johnson's tale suggested otherwise, is that the IMF has generally not been the good or the enlightened guy. I suspect (and hope) that he used that mainly as a literary device ("just look at how much the US is like a banana republic").

You know its a sign of the times when dani rodrik, an economist in the honored ( i like 'em) tradition of hirschmann and jeff sachs has been upstaged on his own blog by an ex economist of the imf (were they not the bad guys who championed the Washington consensus?).

"The conundrum in which the practitioners of "modern political economy" find themselves is the following: either you say that policy is determined by the interests of the politically powerful (here, banks), in which case you are left with no way out (banks will remain powerful and veto any meaningful reform). Or, you accept some autonomous role for the intellectuals and policy makers to make a difference, in which case, you can hardly attribute all the blame for the mess on the special interests. "

Not necessarily, Dani. you can believe that ordinarily the politically connected banks make policy, until they screw up badly enough that their Ponzi scheme is discovered by enough people to make the possibility of their losing power very real. That doesn't mean the action of removing them from power is the solution, just that it is necessary, because of fundamental ergonomic limitations--simply said, some one's heads will have to roll. And roll they will.

The question is: can this reality be leveraged to actually create a solution to the mess that exists, and be more than just entertainment.

We have to have an uprising over AIG bonuses before anything is done. Hedge fund managers are still having their income taxed at capital gains rates. The Tresuary Secretary is about to give these managers a sweet heart deal to bid on toxic assets with tax payer loans that needn't be repayed. Reform of the bankrupcy laws which would give home owners some leverage over the banks is gonng nowhere in congress.

The idea that these things are good for the economy has long ago been swept aside, yet the interests of the financial community allow them to persist, to have their way with congress.

I suspect your words of wisdom only apply to the economists whose hubris lead them to conclusions that were breathtakingly flawed.

Economists are always talking about incentives. I think we'd make better incentives if we didn't make blanket statements that end up ascribing blame to smart economists who had been pointing out the very issues that are causing us trouble today.

Instead we should heap praise upon the Nouri Roubini's amongst us. Reward them for getting it right, and let them try their policies out.

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Economists are always talking about incentives. I think we'd make better incentives if we didn't make blanket statements that end up ascribing blame to smart economists who had been pointing out the very issues that are causing us trouble today.

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